News Analysis: Retrospective tax likely to earn cash-strapped govt Rs44bn

KARACHI: In an unexpected move, the government levied a windfall tax on banks’ profits from foreign exchange dealings. Analysts and bankers believe this was done to increase revenue collection in order to secure a deal with the International Monetary Fund (IMF), rather than penalising banks for engaging in excessive currency speculation. On the recommendation of the Federal Board of Revenue (FBR), the federal cabinet has approved 40 percent tax on banks’ “windfall income” from the foreign exchange business in 2021 and 2022.

It is projected that the government will get Rs44 billion in revenue from the imposition of 40 percent tax on the total income earned by all banks from FX dealings in the last two years.

According to Optimus Capital Management’s calculation of the estimated impact of a retrospective windfall tax on banks, out of the total income from forex dealing of Rs164.541 billion, the banks realised windfall profits of Rs110.1 billion in 2021–2022.

The banks’ income from foreign exchange transactions in 2021 was Rs56.224 billion. These profits came to Rs108.317 billion in 2022.

“It seems the government, in order to get more taxes, approved this step under IMF requirements, otherwise, banks are already taxed at approximately 50 percent,” said a senior banker who asked not to be identified.

“This development may pose challenges for banks, given their operation in a complex forex environment where adherence to State Bank of Pakistan guidelines and maintaining client relationships amidst import payment difficulties are already demanding tasks,” said Chase Securities in a note on Tuesday.

The central bank had repeatedly stated that taxes on banks’ windfall profits from foreign exchange operations that engaged in currency manipulation were under consideration by the government.

Last year, Pakistan’s rupee saw extreme fluctuations and reached record lows against the US dollar, which made authorities suspect manipulation by banks and exchange companies.

“The substantial fluctuation in the currency rate in 2021–2022 led to a 40 percent tax on banks’ foreign exchange gains. The government has taxed it now because the banks’ foreign exchange income over the past two years has been substantial,” said Tahir Abbas, the head of research at Arif Habib Limited.

The banks are already subject to extremely high taxes on their profitability, and this new measure will only hurt them, Abbas said.

In the midst of a foreign exchange crisis, the government put limits on the opening of letters of credit (LCs) for the purchase of specific items in an effort to lower demand for dollars. The nation has to import essential foods like wheat and oil in order to meet its demands and keep its economy afloat in the face of declining dollar inflows. The foreign exchange market was unbalanced and distorted as a result of the massive disparity between dollar supply and demand, according to bankers.

Banks deal in foreign currencies and maintain positions in it on behalf of customers or importers. In this case, banks followed the SBP’s instructions to run short positions in an effort to support import transactions, bankers explained.

When banks expect the value of currency pair to drop, they will enter short bets to reduce losses. Because they were pricing in that risk, banks operated short positions during periods of severe volatility and fluctuation in the local currency.

International banks declined to validate Letters of Credit (LCs) for Pakistani imports, especially petroleum items, prior to the IMF agreement. According to bankers, even the banks that confirmed LCs gave higher rates to Pakistani banks of up to 8 percent, given the unstable macroeconomic conditions of the country and the default risk as measured by credit default swaps.

Was it currency manipulation?